We can easily forgive a child who is afraid of the dark; the real tragedy of life is when men are afraid of the light.â€Â Â Â Â Â Â Â Plato
Well, it seems the unfolding Greek Tragedy was averted, but the patch that was applied does not mitigate the risk of a much larger debacle a short way down the road from here. The Greek Government, whose approach to Government Debt ManagementÂ appears to have consisted of borrowing more than they could afford to pay back and simultaneously lying about it to each other, their neighbours in the EU, the ratings agencies and their investors, has been bailed out using a combination of masking tape and binder twine. The ECB is not impressed. The Germans and French are holding their noses. And the rest of the EU is waiting for the next shoe to drop.
In the end this â€œsolutionâ€ merely papers over the problem, sets a dangerous precedent and waters down the European Monetary Union. That being said, the Greek Crisis is but a symptom of the problems facing financial markets as we move into the second decade of the 21st Century.
Greece is but one economy out of many that are facing serious financial risks centering on the financability of their deficits and their ability to manage this process in a low risk way and with regard to the impact of debt servicing onÂ Government budgets. The second order effects of the Fed-ledÂ rescue plan has exposed serious financial stresses in a number of economies who are having difficulty bearing the strain of funding large deficits.
By way of example, the UK is running a budget deficit of over 12%. In Spain, debt arrears are running as long as 500 days. In the US, personal incomes are still falling and over 50% of homeowners who have had their home loans restructured are defaulting again a mere 9 months later on average. In Mongolia, recent estimates place the ratio of non-performing loans to total bank assets at around 19%. Portugal has just been downgraded. The continued financability of Japanâ€™s public debt is now being thrown into question by shifting demographics. The Eurozone is running a combined deficit of 6% of GDP.
We could go on (and on).
Suffice it to say that the historical record shows that following banking crises the years following the initial shock usually feature a spate of sovereign defaults. For this reason, we expect that rapidly escalating debt levels are likely to force several countries to default and many, including the US to ultimately cut spending in order to rein in ballooning deficits and debt ratios. Based on the numbers that we are seeing, some of which are reproduced in the chart above courtesy of the OECD, we have no doubt that renewed, and significant financial stress, is in store.
The gross borrowing needs of OECD countries are expected surpass $13 Trn. in 2010 and remain elevated for some time. Much of this incremental issuance will be in short term markets. This is because issuance conditions remain unsettled featuring weak demand at long term debt auctions. Moreover, both primary and secondary market fundamentals have been negatively impacted by the disappearance of some primary dealers and the generally weaker balance sheets among the survivors.Â In the US for example the number of primary dealers has dropped from 46 firms in 1998 to only 17 today. In addition the demise of numerous banks has also removed liquidity from the primary and secondary markets
Together with the decline in liquidity referred to above, issuance conditions have become tougher in general due to the larger financing needs of governments. The demand for funding has intensified at the same time that investors have become more conservative in their allocations. Lower rated borrowers are increasingly being forced into the shorter-term markets with a consequent increase in coupon reset risk, rollover risk and liquidity risk in their debt portfolios. Many debt managers are now organising road show events, changing issuance methodologies and beefing up capacity and capability in order to cope with the grim conditions.
The implication for government financial management is obvious: donâ€™t borrow if you donâ€™t have to; use your domestic sources of funds and avoid the international markets and offshore debt capital as much as you can; develop debt management expertise, policies, systems and procedures if you do not have them; and improve them if you do. The â€œgales of destructionâ€ are only just beginning to blow again.
The last line was a homage to Joseph Schumpeter.Â A friend at Carleton UniversityÂ in Ottawa sent us this homage to JM Keynes and FA Hayek. Please have a look. We are all “in the test tube nowâ€ and are sure that you will find that this little video proves to be six minutes of your time well spent.